The Securities Litigation Expert Blog

Puerto Rico Municipal Bond Crisis - Understanding Closed-end Bond Funds

Posted by Jack Duval

Nov 22, 2013 8:44:00 AM

Much of the litigation about the Puerto Rico municipal bond crisis involves leveraged closed-end bond funds, in particular those sold by UBS.  As part of our continuting expert analysis of this crisis and subsequent litigation, we have prepared a short primer to help litigants understand closed-end municipal bond funds.

Understanding Closed-end Municipal Bond Funds

Closed-end funds are initially offered through an underwriting and the number of shares remains constant. These shares will then typically be traded on an exchange. Unlike their open-end cousins, closed-end funds may trade at, above, or below net asset value. Typically, municipal bond funds will trade near or below their new asset value, although they do trade above their net asset value on occasion.

Traditionally, closed-end municipal bond funds have distributed the net income generated by the underlying bonds in the portfolio. More recently, some funds have been using a “managed distribution” policy. Under a managed distribution policy, the closed-end fund sets a distribution rate and if the underlying municipal bonds do not generate enough income, principal is used to bring the total distribution up to the predetermined level.

Managed Distributions

Over time, a managed distribution policy can erode the principal amount invested in the fund. This can be a significant risk for the investor if they rely on their investments for living expenses, as in the case of retirees. For such an investor, a managed distribution policy can facilitate the unknowing consumption of their own principal. This could leave them with a depleted asset base from which to generate income for their expenses.

Most investors are unaware of managed distributions and assume the distributions they receive from closed-end bond funds are interest payments from the underlying funds. FINRA published an Investor Alert on October 28, 2013 to address these issues and explain the differences between an investment yield and a distribution. [1] In this Investor Alert, FINRA explains:[2]

"When looking at closed-end funds and traditional mutual funds, keep in mind that distribution rates and yields are different measures. A mutual fund's yield shows its interest and dividend income expressed as a percentage of the fund's current share price. With a closed-end fund, the distribution rate might also include a return of principal…
Closed-end funds that return capital can carry a higher level of risk because the fund is eroding the asset base it has to generate income to pay distributions. Some closed-end funds set a specific distribution rate to pay regardless of the income generated by the fund. In that case, it is more likely that a fund may return capital to investors along the way. Before you invest in a fund, find out if the closed-end fund follows this approach—also known as a managed distribution policy."

Furthermore, investors might not want to invest in a new issue closed-end bond fund (where a 4.5 percent commission is typically charged on the total amount invested) if the fund is going to return their own principal back to them.

Accelerant will have a white paper from fixed income expert Gerry Guild, analyst Jay Dulski, and CEO Jack Duval coming soon.

Footnotes

[1]                 See FINRA Investment Alert “Closed-End Fund Distributions: Where is the Money Coming From?”, 10/28/13. Available at http://www.finra.org/Investors/ProtectYourself/InvestorAlerts/TradingSecurities/P373690; Accessed November 22, 2013.

[2]                 Id.

 

 

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Topics: Puerto Rico Municipal Bond Crisis, Closed-end municipal bond funds, Managed distributions

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